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Dividends are the hottest niche in the exchange-traded fund world, and there's little mystery why.

It's interest rates. Bonds, money market funds and certificates of deposit are paying out such paltry sums to savers that the dividend yield of the Standard & Poor's 500 not only exceeds the interest rate on 10-year U.S. Treasury bonds but now does so by more than half a percentage point -- 2.1% versus 1.5%. "If you look at the traditional income products, many of them actually have negative real returns when you factor in inflation," says Neena Mishra, director of ETF research at Zacks Investment Research. "Income investors are looking for alternatives, and many of them are turning to dividend ETFs."

Since the start of 2011, the number of dividend ETFs has soared from 29 to 49, according to Morningstar, and the total assets under management in the category has ballooned from $22 billion to $47 billion. This is one instance where investors are clearly not chasing performance, as the category has produced rather mediocre total returns.
iShares Dow Jones Select Dividend Indexdvy 0.4024594745667971%iShares Select Dividend ETFU.S.: NYSE Arca89.81
0.360.4024594745667971%
/Date(1481329800002-0600)/
Volume (Delayed 15m)
:
1458923AFTER HOURS84.45
-5.36-5.96815499387596%
Volume (Delayed 15m)
:
225
P/E Ratio
N/AMarket Cap
N/A
Dividend Yield
3.08689900901904% Rev. per Employee
N/AMore quote details and news »dvyinYour ValueYour ChangeShort position
(ticker: DVY) -- one of the oldest dividend ETFs and, until recently, the largest -- lost 0.9% every year, on average, over the past five years, while the S&P 500 lost 0.3% in the same period. It hasn't fared any better in 2012; DVY's year-to-date return is 6.3%, while the S&P has returned 7.9%. By comparison, Morningstar's equity-income mutual-fund category also trails the S&P; the category has lost 2.6% annually over five years, and returned 5.4% year-to-date.

Latest ETF Investing Strategies

Still, if you want income and can accept the fact that the monthly dividend payments will not be as predictable as, say, income from a bond fund, dividend ETFs do have appeal. Like other equity ETFs, they track stock indexes that are usually well-diversified and easy to buy and sell, and they have lower expense ratios than comparable actively managed mutual funds. The largest dividend ETF, for instance,
Vanguard Dividend Appreciationvig 0.7079029824765%Vanguard Dividend Appreciation ETFU.S.: NYSE Arca86.78
0.610.7079029824765%
/Date(1481329800000-0600)/
Volume (Delayed 15m)
:
632781AFTER HOURS86.78
%
Volume (Delayed 15m)
:
893
P/E Ratio
N/AMarket Cap
N/A
Dividend Yield
1.811477298916801% Rev. per Employee
N/AMore quote details and news »viginYour ValueYour ChangeShort position
(VIG), has an expense ratio of only 0.13%, even cheaper than the already-cheap
Vanguard Equity-Income fund
(VEIPX), which charges 0.31%. That expense difference comprises a big chunk of the performance gap between Vanguard's ETF (five-year annual total return: 1.9%) and its actively-managed equity-income cousin (1.22%). "The lower-expense products tend to do very well," says Michael Iachini, ETF analyst at Charles Schwab Investment Advisory, which consults on portfolio construction for individuals and advisors.

Investors who buy dividend ETFs do need to keep close tabs on their funds' holdings. One problem is that the indexes these funds track tend to favor stocks with the highest dividend yields, and those stocks aren't always the highest quality companies, which means investors could be setting themselves up for a problem. The highest-yielding stock in the S&P 500, for instance, is
Duke EnergyDUK 1.4585842365850394%Duke Energy Corp.U.S.: NYSEUSD75.82
1.091.4585842365850394%
/Date(1481320925865-0600)/
Volume (Delayed 15m)
:
3164982AFTER HOURSUSD75.82
%
Volume (Delayed 15m)
:
31137
P/E Ratio
18.280010608288933Market Cap
51488972312.9273
Dividend Yield
4.510683197045634% Rev. per Employee
796526More quote details and news »DUKinYour ValueYour ChangeShort position
(DUK), which has a 13.8% dividend yield but a world of management and acquisition troubles. "For some investors, active management probably is the way to go when it comes to income-oriented products," says Amy Charles, director of closed-end fund research at Raymond James Financial.

In other words, if you're going to buy Vanguard Dividend Appreciation -- a fund that has outperformed its category over the past five years and is a favorite of Morningstar ETF analyst Timothy Strauts -- or any other dividend ETF -- you need to check the holdings regularly. If you don't, you run the risk of getting into the kind of trouble investors in dividend ETFs found themselves in five years ago.

Any dividend-stock index that puts a premium on high dividends could back shareholders into a disproportionate number of low-quality stocks—particularly if corporate earnings are in decline. That's exactly what happened in 2008 and 2009, when many of the highest-yielding stocks heading into the financial crisis were bank stocks. Bank managements were slow to cut dividends even as the crisis deepened, which caused bank-stock dividend yields to soar. (Yields often move in the inverse direction of stock prices.)

Consequently, several dividend ETFs wound up formulaically increasing their exposure to financials at a time when the human managers of traditional equity income funds were cutting back. "DVY got killed because it loaded up on financials right as the crisis started," says Strauts. Between September 2008 and March 2009, Dow Jones Select Dividend's share price fell 56%. Another dividend ETF,
PowerShares High Yield Equitypey 0.763807285546416%PowerShares High Yield Equity Dividend Achievers PortfolioU.S.: Nasdaq17.15
0.130.763807285546416%
/Date(1481320800201-0600)/
Volume (Delayed 15m)
:
479691
P/E Ratio
N/AMarket Cap
N/A
Dividend Yield
3.046530612244898% Rev. per Employee
N/AMore quote details and news »peyinYour ValueYour ChangeShort position
(PEY), became even more overexposed to financials -- in October 2008 bank stocks comprised 55% of total assets -- and it wound up losing 67% over the same period.

The same goes for international or emerging-markets ETFs, many of which have alluringly high yields, anywhere from 4% to 10%. That may make them a smarter way to play emerging markets, but they're not a replacement for income investors concerned about safety and steadiness. Among the challenges associated with investing overseas -- and especially in emerging markets -- are lax accounting standards and uneven enforcement in countries such as China.

The Largest Dividend ETFs

The ETF industry is highly concentrated, and when it comes to picking a fund, bigger is often better. While there are 49 dividend-focused ETFs on the market with a total of $47 billion in assets, the 10 largest make up more than 90% of those assets, or $43.5 billion. Stick with the well-established funds.